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Probability and risk: Foundations and economicimplications of probability-dependent risk preferences


Fehr-Duda, Helga; Epper, Thomas (2012). Probability and risk: Foundations and economicimplications of probability-dependent risk preferences. Annual Review of Economics, 4(1):567-593.

Abstract

Probability weighting has been largely ignored by economics despite abundant evidence that riskattitudes are in fact probability dependent. Probability weighting, however, provides a unifyingaccount of many real-world phenomena that are diffcult to reconcile with expected utility theory,such as the equity premium puzzle, the long-shot bias in betting markets, households'underdiversification and their willingness to buy small-scale insurance at exorbitant prices. Recentfindings suggest that probability dependence is not just a feature of laboratory data but is indeedpresent in financial, insurance and betting markets. Thus, the neglect of probability weightingprevents economists from comprehending important phenomena. In this paper, we discuss thefoundations and economic consequences of probability weighting and offer a practitioner's guideto understanding and modeling probability-dependent risk preferences.

Probability weighting has been largely ignored by economics despite abundant evidence that riskattitudes are in fact probability dependent. Probability weighting, however, provides a unifyingaccount of many real-world phenomena that are diffcult to reconcile with expected utility theory,such as the equity premium puzzle, the long-shot bias in betting markets, households'underdiversification and their willingness to buy small-scale insurance at exorbitant prices. Recentfindings suggest that probability dependence is not just a feature of laboratory data but is indeedpresent in financial, insurance and betting markets. Thus, the neglect of probability weightingprevents economists from comprehending important phenomena. In this paper, we discuss thefoundations and economic consequences of probability weighting and offer a practitioner's guideto understanding and modeling probability-dependent risk preferences.

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16 citations in Web of Science®
18 citations in Scopus®
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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Economics
Dewey Decimal Classification:330 Economics
Language:English
Date:1 January 2012
Deposited On:14 Jun 2012 15:23
Last Modified:05 Apr 2016 15:52
Publisher:Annual Reviews
ISSN:1941-1383
Publisher DOI:https://doi.org/10.1146/annurev-economics-080511-110950
Other Identification Number:merlin-id:7056, Annu. Rev. Econ. 2012. 4:19.1–19.27
Permanent URL: https://doi.org/10.5167/uzh-63137

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